Introduction to Options Pricing Using Binomial Trees

Gouthaman S. Balaraman, Ph.D.

goutham@gatech.edu

1 Introduction
Options are derivative instruments that gives its owner the right, but not an obligation, to engage
in some specific transaction on an underlying asset, where the underlying asset can be a stock,
bonds etc. Various techniques such as Black-Scholes model, and Monte Carlo methods are used to
price options contract. But each of these techniques have their limitations. For instance, Black-
Scholes model is a theoretical technique that can value European options under the assumption
that the volatility of the underlying asset is constant. Monte-Carlo technique is very powerful and
have a rather general scope, though they can be computationally expensive. Given the complexity
involved in some of the options contracts, very often these techniques are not quite adequate. The
objective of this report is to give an introduction to the binomial tree technique, and its application
in option pricing.
The binomial tree approach is a very powerful technique and an application to price various
kinds of options contracts can be found in reference [1, 2]. Applications of binomial trees to pricing
convertible bonds can be found in reference [3]. In this report, we will focus on introducing the
concept of binomial trees by pricing European options. In section 2, we construct the simplest
possible binomial tree, and show how an option can be priced. In section 3, we generalize the idea
of binomial model by constructing a multi-step binomial tree, and we discuss an example of pricing
an option in detail.

2 One-step binomial tree

2.1 Building the stock prices
An important general principle used in options pricing is the risk-neutral valuation. According to
this principle, the current value of an asset is the same as the expected value of the asset at future
time T , E(ST ), discounted by the risk-free rate,

S0 = E(ST ) e−rT .

The continuous compounding risk-free rate is r, the asset price at time T is ST , and the current
asset price is S0 . To illustrate, say the current trading price of IBM stock is $100. Say we expect
the IBM stock to move up or down by $10 a year from now, as shown in Figure 1(a). What are the
probabilities for the stock to reach $110 and $90? Lets assume we live in a interest free world, (i.e)
r = 0. According to risk-neutral valuation, the expected value of the future prices of IBM should
be the current price of the stock (note in interest-free world erT = 1). Thus we can write

$100 = p × $110 + (1 − p) × $90,

which yields a 50% probability for the price to move up or down by $10. We just tacitly created a
binomial model for IBM stock price movement! Lets see how this concept can be further used to
price options.
 a) IBM stock prices b) IBM call prices
$110 $5
p p

$100 $c0

1-p 1-p

$90 $0
One Year One Year
Figure 1: A binomial tree of IBM (a) stock prices and (b) call option payoff.

2.2 Pricing an option

Lets say we have a European call option on IBM stock with strike price K of $105 and 1 year to
maturity. How do we price the value of this option? The value of the call option, CT , at the time
T of maturity, will be
CT = max(ST − K, 0),
where ST is the price of the IBM stock at maturity. At maturity, if the price of the stock is greater
than K, one can exercise the option and buy the underlying for price K and sell it in the market
for ST , and hence the option is worth ST − K. If the stock is worth less than the strike K at
maturity, then the call is worth nothing, since the owner of the call would find it profitable to
directly purchase the underlying from the market. In our two-state model for IBM stock prices, we
can write down the payoffs from the options contract at maturity as shown in Figure 1(b). Using
the risk-neutral probabilities calculated in the previous section, we can calculate the current price
of the call as
$C0 = 0.5 × $5 + 0.5 × $0 = $2.5
The theoretical estimate for the call price using the Black-Scholes formula is $2.06 (details of this
calculation provided in Appendix). The simplest binomial model price has about 20% error. But
we can improve the accuracy by pricing the option on a multistep binomial tree. We present a
more general approach to pricing options in the following section.

3 Multi-step binomial Tree

3.1 Building the stock prices
In a typical scenario when we want to price an option, we would know the current price S0 of the
underlying asset (like a stock), risk free interest rate r, and the variance ν of the stock price return.
Let us see how we can construct a binomial tree that is consistent with the initial parameters that
we have in hand. Let the price of a stock be S0 at time t0 , and its price at time t1 be either
S0 u or S0 d, where u or d represent the factor by which the stock price changes up and down
respectively. Let the probability for moving up and down be p and 1 − p respectively. This is
shown in Figure 2(a) below. Calculating the expected return from the stock at t1 and making use
of risk-neutral valuation,

E(St1 ) = pS0 u + (1 − p)S0 d = S0 er(t1 −t0 ) ,

we get

er(t1 −t0 ) − d
p = (1)
u−d

a) One-step tree b) Two-step tree

S0 u2
p
S0 u
S0 u
p p 1-p

S0 S0
p S0 ud = S0
1-p 1-p
S0 d S0 d
1-p
S0 d2

t0 t1 t0 t1 t2
Figure 2: A schematic of the (a) one-step tree, and (b) two-step tree showing stock price movement.

We need to chose appropriate values for the parameters u and d which can be obtained from
equating the variance of the return to ν = σ 2 ∆t. Here, ∆t = (t1 − t0 ) and σ is the volatility of
the stock, which we assume to be a constant here. The variance of the stock price return on the
binomial tree is:
pu2 + (1 − p)d2 − [pu + (1 − p)d]2 = σ 2 ∆t
On ignoring terms of order higher than ∆t2 and imposing the condition ud = 1 (explained below),
we get
√ √
u = eσ ∆t
d = e−σ ∆t
. (2)

Some of the equations have been provided here for completeness. What is more important is
that, given the volatility σ of a particular stock (usually available in sites like Google Finance), we
can construct a binomial tree in a time interval ∆t = t1 − t0 for future stock price movements as
S0 u and S0 d where u and d are given as in Equation 2, and the probability p associated with stock
price movement is given by Equation 1. Once we have constructed the stock price at time t1 , we
can construct the prices at time t2 starting from each node in time t1 in a similar way, as shown
in Figure 2(b). The condition ud = 1 that we have imposed means that that the two branches
from the nodes at t1 recombine at time t2 . The overall movement of stock at any time can thus be
constructed using a number of steps in a binomial tree. A concrete example along with a procedure
to calculate a call price is shown below.
3.2 Pricing the option
Here let us explore how to price a European option using a multi-step tree constructed previously.
Let C0 be the current value of an option on a stock. Let the payoff of the option after one step
(time ∆t) on a binomial tree be Cu and Cd for up and down movement respectively of the stock.
The value of the option in this case is given as:

C0 = e−rT [pCu + (1 − p)Cd ]. (3)

In a scenario when we have a multi-step binomial tree for the underlying, the payoff is first written
out at the time of maturity. Then the price of the other nodes are worked backwards using the
Equation 3. To get a concrete understanding, lets price the European call example for the IBM
stock seen above, using a multi-step tree.
Let the current stock price S0 = $100, volatility of the stock σ = 10%, risk-free interest rate
r = 0, strike price of the call K = $105, and time to maturity T = 1 year. Lets construct a binomial
tree having two steps in a time span of one year, i.e ∆ = 0.5. Using the Equation 2 described above
in section 3.1, we get √
u = e0.1∗ 0.5 = 1.07,
√
d = e−0.1∗ 0.5
= 0.93.
The Equation 1 gives us the probability for transition as

e0×0.5 − 0.93
p= = 0.48.
1.07 − 0.93
Using the values for u, d and p, we can construct a two-step binomial tree for stock prices as
shown in Figure 3(a). Once we have a binomial tree for stock prices, it is fairly straight forward to
calculate the call price at maturity,

CT = max(ST − $105, 0),

also shown in Figure 3(b). Using the price of the option at maturity, we can construct the price of
the option at 1/2 year by using Equation 3,

Cu = 1 × [0.48 × $9.5 + 0.52 × $0] = $4.56,

Cd = 1 × [0.48 × $0 + 0.52 × $0] = $0,

as shown in Figure 3(c). Finally, we can use the prices calculated for Cu and Cd and repeat the
same procedure to get the option price C0 at the current time as

C0 = 1 × [0.48 × $4.56 + 0.52 × $0] = $2.18,

as shown in Figure 3(d). The option price calculated from the two-step tree has only 5% error,
down from 20% for the price from one-step tree. Thus, the accuracy of the option price calculation
can be improved by increasing the number of steps in the binomial tree model. The general steps
involved in calculating the price of an option using a multi-step tree is:

• Build the basic binomial tree of stock price in future time, starting with S0 at time t0 . At
time t1 , the possible stock price values are (S0 u,S0 d). At time t2 , the possible values are
(S0 d2 , S0 ,S0 u2 ) and so on until time to maturity T .
 a) Stock price b) Call price - step 1
$114.5 $9.5
0.48 0.48

$107.3 Cu
0.48 0.52 0.48 0.52

$100 C0
0.48 $100 0.48 $0

0.52 0.52
$93.2 Cd
0.52 0.52
$86.5 $0
0 1/2 yr 1 yr 0 1/2 yr 1 yr

c) Call price - step 2 d) Call price - step 3

$9.5 $9.5
0.48 0.48

$4.56 $4.56
0.48 0.52 0.48 0.52

C0 $2.18
0.48 $0 0.48 $0
C
0.52 0.52
$0 $0
0.52 0.52
$0 $0
0 1/2 yr 1 yr 0 1/2 yr 1 yr
Figure 3: A two step tree diagram of (a) stock prices, (b,c,d) and call prices.

• Calculate the payoff from the option at the time of maturity, which for a European call is
max(ST − K, 0).

• Calculate the value of the option for all nodes at earlier time steps by using risk-neutral
valuation, working backwards until time t0 .

A plot comparing the theoretical price of this option as a function of the number of steps is shown
in Figure 4. The error in the option price using 100 steps is less than 0.4%, and this computation
took only 20 milli-seconds in Mathematica on a 2GHz processor!

4 Conclusion
In this report, we have introduced the basic idea of options pricing using the binomial trees. Here
we have discussed the (rather trivial!) example of European options. But the real strength of
binomial model approach is its versatility in pricing rather complex instruments such as American
options, barrier options etc. This report serves as a simple introduction to the idea of binomial
trees, and the reader is encouraged to pursue other references [1, 2, 3] for more details.
 2.4

Option Price
2.2
2.0
1.8
1.6
0 20 40 60 80 100
Number of Steps
Figure 4: A plot of the call price as a function of number of steps in the binary tree model (blue),
compared against the theoretical Black-Scholes price (dashed red). The Black-Scholes price is $2.06.

References
[1] Neil A Chriss, Black-Scholes and beyond: option pricing models, McGraw-Hill (1996)

[2] Gouthaman S Balaraman, Options pricing using binomial trees,

http://www.scribd.com/doc/4108897/Options-Pricing-Using-Binomial-Trees

[3] John C. Hull, Options, Futures, and Other Derivatives

Appendix
The Black-Scholes formula gives the theoretical price for European option. The Black-Scholes price
C of an option is

C = S0 N (d1 ) − Ke−rT N (d2 ) (4)

where S0 is the current price of the underlying, the risk free rate is r, the volatility of the underlying
is σ, and time to maturity is T . The terms d1 and d2 are,

ln[S0 /K] + (r + σ 2 /2)T

d1 = √ ,
σ T
ln[S0 /K] + (r − σ 2 /2)T √
d2 = √ = d1 − σ T
σ T
and N (x) is the cumulative distribution function for a Gaussian distribution with zero mean and
unit variance. Before we can compute the Black-Scholes price for the example discussed in sec-
tion onesteptree, we need to estimate the volatility for the IBM stock based on the stock prices.
The volatility σ for a stock given in a binomial tree shown in Figure 2(a) is given as
1
σ= ln(Sup /Sdown ).
2(t2 − t1 )

Using this expression, we can compute the volatility for the IBM stock prices given in Figure 1(a),

σ = 0.5 × ln(110/90) = 0.10 = 10%.

On substituting the parameters r = 0, σ = 10%, K = $105, S0 = $100, in the Black-Scholes

formula, we get the theoretical price C = $2.06.